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How the ECB was spooked into changing its stance on inflation

A surge in eurozone inflation transformed this week’s meeting of the European Central Bank’s governing council from what was widely expected to be an unremarkable event into a turning point for the bloc’s monetary policy.

The shift towards a more “hawkish” stance came on the back of January’s record eurozone inflation figure, released shortly before the start of a two-day virtual meeting on Wednesday, according to five people involved.

The rise seemed to spook many of the ECB council members who had until recent days believed the surge in prices in the final six months of 2021 was “transitory” and would quickly fade this year, not least because the inflationary effects of Germany reversing its temporary sales tax cut would have dropped out of the data.

Instead of falling, however, inflation rose further above the ECB’s 2 per cent target for the seventh consecutive month to set a new eurozone record of 5.1 per cent. While about half of this was down to double-digit rises in energy costs, price pressures were also broadening: the cost of six out of 10 items in the basket used to calculate inflation rose over the past year.

This led ECB rate-setters to agree that their president Christine Lagarde should use the press conference after its Thursday meeting to signal a likely U-turn. The best way to do this, they decided, was for her to stop dismissing the idea of a rate rise this year.

Lagarde’s subsequent comments, including her remarks that inflation risks were “tilted to the upside” and that it was “getting much closer to target”, sparked a sell-off in bond markets and a surge in the euro — emphasising the pivotal nature of the move.

The second factor behind the central bank’s shift was the rapid rebound of the labour market from the pandemic. This was driven home for ECB policymakers on Tuesday when Eurostat said eurozone unemployment had fallen to a record low of 7 per cent, due in large part to a drop in joblessness among young people to an all-time low of 14.9 per cent.

Further evidence of the labour market’s recovery came from the European Commission, which revealed a few days earlier that record numbers of both manufacturing and services companies were complaining of worker shortages. Wage growth in Europe remains below that of the US and UK, but council members seem increasingly convinced it will pick up this year.

The ECB said on Friday that after surveying 74 non-financial companies in January it found “they expected average wage increases to move from around 2 per cent in the recent past to 3 per cent or possibly more this year”.

Line chart of % of businesses reporting labour as a factor limiting output showing Eurozone businesses are facing unprecedented labour shortages

The final factor convincing the remaining “doves” on the ECB council to rethink their position came when US Federal Reserve chair Jay Powell sparked a stock market sell-off last week by refusing to rule out more aggressive interest rate rises this year than markets had expected. Furthermore, all the signs pointed to the Bank of England raising rates for a second time in three months on Thursday — as it duly did.

Lagarde was quick to point out that the eurozone is in a very different place to both the US, where a vast fiscal stimulus has driven demand well above pre-pandemic levels, and the UK, where Brexit has amplified pressure on the labour market and driven up wages.

However, the “hawkish” shift in policy by both the Fed and the BoE risked leaving the ECB looking like “the last dove standing’‘ — as Allianz economist Katharina Utermöhl described it this week. One ECB council member said it risked tightening policy “for credibility reasons, not for fundamental reasons”. But others said there was a widely shared feeling that the Fed and BoE had found themselves behind the curve on inflation and the ECB did not want to end up in the same tricky position.

So where does this leave the ECB? Several of the more conservative “hawks” on the council spoke out at Thursday’s meeting in favour of clearly communicating plans for an accelerated end to bond purchases, which are due for a “step-by-step” reduction this year but still have an open-ended timeline.

However, the “hawks” eventually agreed to wait until the ECB’s next policy meeting in March, when it is likely to raise its inflation forecast above 2 per cent for the next two years — fulfilling a key condition for it to eventually raise rates.

One of those calling for a change in policy to be announced more quickly was Joachim Nagel, the new Bundesbank president, though a spokesman for Germany’s central bank said he was “very happy” with the outcome of Thursday’s meeting.

An extra factor complicating the ECB’s position is the rising tension between Russia and Ukraine. If Russia invades its neighbour energy costs are likely to rise further, but if tensions ease prices could fall. The issue was briefly discussed at this week’s meeting, but most ECB rate-setters feel powerless to either predict how the saga will end or to influence energy prices.

In response to Lagarde’s press conference, traders increased their bets on higher euro area interest rates, with markets pricing in several increases in the ECB deposit rate from minus 0.5 per cent to minus 0.1 per cent by December.

However, most council members think this is too aggressive. Even more “hawkish” central bank officials dismiss the idea of a rate rise this summer as “ludicrous” and say the earliest it is likely to happen is the fourth quarter.

This would mean the ECB continues to lag behind the Fed and BoE in tightening policy to combat high inflation. But given that the last time the ECB raised rates was on the eve of the eurozone’s sovereign debt crisis in 2011, most council members seem comfortable with it taking a more cautious approach this time.

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